Should you use a reverse mortgage in retirement?

PeterRueth

Research by the Insured Retirement Institute reflects that 24% of baby boomers have no retirement savings – which is the lowest number recorded since the beginning of the study in 2011.

Another sobering data point shows only 55% of baby boomers have some retirement savings and, of those, 42% have less than $100,000. Thus, approximately half of retirees are, or will be, living off of their Social Security benefits.

Even retirees who have been successful in saving have big concerns because of rising medical costs and increased life expectancy. Retired baby boomers and those quickly approaching retirement are troubled their nest egg savings will fall short and risk outliving their retirement funds. Retirees, and financial advisers, are continually looking for ways to maintain a healthy and fitting quality of life during years in retirement.

A major component of wealth and retirement planning often overlooked or ignored, is home equity. Based on U.S. Census Bureau figures, collected in 2011 and dated 2013 the average married couple entering retirement will have a net worth of $194,226. However, when home equity is removed net worth drops to just $43,921. With 77% of a retiree’s net worth locked in home equity it’s astonishing why so many financial planners ignore home equity when creating retirement plans. There is currently over $6.3 trillion in senior housing wealth and its growing daily as 10,000 people turn 62 every day. Although recent changes to the fiduciary standard do not explicitly include home wealth, it no longer can be ignored as part of the overall retirement plan.

In April 2016 Jamie Hopkins, professor of tax at the American College’s Retirement Income Certified Professional program, wrote an article for InvestmentNews titled “Baby Boomers’ Wealth is in Their Homes.” Hopkins counsels financial advisers that home equity can no longer be forgotten, “Far too many financial advisers overlook home equity as part of a retirement income plan. With heightened regulatory concerns about doing what is in the best interest of the client, it would be prudent to explore and discuss home equity strategies with clients. Remember, there’s no magic home equity strategy that always works best. As an adviser, you need to incorporate home equity solutions into the client’s unique situation.”

Too often a reverse mortgage is advised as a quick fix for cash, or worse, as a loan of last resort when all else fails. Working with a well-versed financial adviser a reverse mortgage can be customized to meet or complement a number of retirement financial goals. These goals may include long-term care planning, purchasing the right house, improving cash flow, mitigating sequence of returns risk in market downturns, delaying other income streams, or simply providing peace of mind for unexpected expenditures.

Clients should consider many factors when looking at a reverse mortgage, such as estate wishes, costs, and using home equity to help with retirement cash flow, says Kristi Sullivan, owner of Sullivan Financial Planning in Denver.

For most over 62, housing costs are the single biggest expense throughout retirement. It’s an expense requiring careful planning and if left unchecked, can derail a retiree’s financial security. In 2014, the National Association of Realtors estimated over 700,000 homes were sold to seniors over the age of 62. About 60% were financed with a traditional mortgage with required monthly payments. Only a few thousand sold were financed with a home equity conversion mortgage, or HECM, for purchase. Most people are not aware that someone over 62 can purchase a home with the FHA approved HECM product commonly referred to as the “H4P.” Eliminating or making a mortgage payment optional throughout retirement cannot be underestimated as a valuable strategy.

H4P works this way: At age 62 the HECM requires roughly 50% equity. As the age of the borrower goes up the amount of equity required goes down. To purchase a house with the H4P, the 62-year-old home buyer will have a down payment of approximately 50% of the purchase price. For example, to purchase a $400,000 home, a buyer could bring in $200,000 plus any closing costs (perhaps in equity from a home just sold). Then the reverse mortgage balance will start at about $160,000 with no required ongoing payments other than taxes and insurance. Not having to make monthly mortgage payments will result in hundreds of thousands of dollars in cash flow for the next 15-20-30 years on a $400,000 home.

If not utilizing a H4P, a home buyer typically has two other options when purchasing a home. The second option is to pay cash in full which eliminates the ability to use any of the $400,000 for investments or extra funds to improve retirement. In this case the cash spent is stuck in the home until the owner moves or passes away. Heirs may get use out of it but the home buyer never will. The third option is a conventional mortgage. Assuming borrowers are able to qualify; they will typically pay $80,000 for a down payment and finance the remainder over 30 years in order to get the most affordable payment. Assuming an interest rate of 4.25%, this would result in monthly mortgage payments of about $1,600. Over 30 years the borrower will pay nearly $575,000 plus the original $80,000 down payment for total expenditures of $656,000. It’s obvious the least amount of cash flow— despite the large up front down payment— is accomplished with the H4P.

Making a move might not be of interest for a retiree. Perhaps looking for money to supplement income is of top importance. Based on the same Census Bureau data, the average person going into retirement has a net worth of $194,226. If they expect to spend 4% a year from their retirement savings, that allows for $7,769 a year or less than $650 a month. Even with the average monthly Social Security benefit at $1,341 (2016 data), that’s still less than $2,000 a month in retirement income.

A reverse mortgage can be structured using the tenure payment to provide a monthly payment similar to an annuity or a pension. The tenure payment provides equal-sized cash payments for an indefinite length of time as long as the house is the primary place of residence, property tax, homeowners insurance and HOA are paid, and the owner continues general maintenance of the house as is required on any mortgage. Even if over time the tenure payments exceed the original principal balance, a monthly payment is guaranteed to be delivered.

Jay Clark, founder of Lucet Advisors in Greenwood Village, Co., adds, “When I’m helping a couple prepare for their retirement, I want to make sure their story works under the greatest levels of variance. They have no idea what the next two to three years of their life will hold, much less the next 20 to 30 years, so we need as many flexible, open-ended big buckets of cash as possible to handle whatever life is going to throw their way.”

Astute pilots will never leave the ground without sufficient fuel in their reserve tank. It’s never the intent of a pilot to use reserve fuel unless absolutely necessary. Many go flying into retirement with only their cruising tank full expecting these funds to meet their needs. However, rarely does someone go through retirement on auto pilot. An unforeseen illness or injury can quickly deplete savings. Unexpected expenses aren’t always undesirable events. Maybe a child or grandchild needs funds for a down payment on their first home or seed money for a new business. Many would prefer to make a generous contribution to a charity while they are alive

A powerful feature of a reverse mortgage is the line of credit. A line of credit can be established to create the reserve tank of funds to be used for unexpected or the otherwise wishful spend (think corvette or fishing boat). Unlike aircraft fuel tanks, the reverse mortgage line of credit is a reserve tank of funds that will continue to grow each year.

An extremely important feature of the line of credit reverse mortgage is any unused portion of the credit line grows at the same effective rate that’s applied to the loan. Even in increasing interest rate markets the line of credit will continue to grow as the effective interest rate increases.

Unlike a traditional bank home equity line of credit (HELOC), the reverse mortgage line of credit is the one credit line that can never be frozen or closed while the borrower is still living in the house. This would apply even during the worst economic times. For this reason alone, many opt to establish the reverse mortgage line of credit purely as a safety net of funds for the case of the unexpected.

Whether used as a refinance or a purchase, or a line of credit or monthly tenure payment, it can make a dramatic difference in portfolio longevity. The most interesting thing about the recent research published in the journal of financial planning is very counterintuitive and may be the biggest reason for advisers to incorporate reverse mortgages into retirement plans. Research shows seniors who take reverse mortgages out at 62 instead of 82 or 92 preserve many other forms of wealth and actually increase their net worth during retirement as compared to waiting and using home equity as a loan of last resort. Any strategy that increases cash flow, increases portfolio longevity and slows the decline of net worth deserves a second look.

Despite a bad reputation, this FHA government-insured product has a lot more advantages than disadvantages and fiscally responsible retirees should consider incorporating it into their overall retirement plan. Equally important, financial advisers must discuss with clients and take into consideration what role home equity plays in their overall retirement plan.

Peter Rueth is a Reverse Mortgage Planner with Fairway Independent Mortgage Corporation in Denver and a member ofFPA of Colorado.

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